Monday, January 22, 2018

The 2018 Treasury Bond Bear Market?

The benchmark U.S. 10-year Treasury has entered a predictable mild bond bear market, and the financial press has rolled out their "What happens when the Treasury Market Dies?" think pieces. (As an immediate disclaimer, I do not do forecasts, and thus I did not "predict" this bear market. At most, I probably noted that previous pricing was consistent with a decent probability of recession happening over the next few years.) As is usual, we are seeing a lot of technical analysis. The technical analysis battle is between two forces: the drawing straight lines is destiny belief, versus the belief in the power of round numbers.

The "straight lines are destiny belief" is fairly well known; it is easy to draw a descending straight line on a long-term bond yield chart (like the one above). The latest move probably broke above a lot of the lines that you could draw. The next logical step is the following: if bond yields are no longer going down, they have to go up.

This is going to collide with the "big round numbers" theory. The theory is that a lot of asset allocators/bond managers have said: "I will cover my short/underweight when the yield hits a round number (3% in this case)." I no longer pay attention to market chatter, but anecdotes about liability managers having hedging programmes kick in at those round number levels was a constant across all developed markets.

As a recovering secular bond bull, I have a natural affinity for the "round numbers" theory. Anyone selling stories about a bond market apocalypse has to explain why institutional investors that are massively short duration versus their liabilities are going to let yields shoot higher. (By contrast, most institutional investors did not even know how to calculate the duration of their liabilities before the early 1990s.) That said, a 3% nominal yield is pathetically low in an environment where nominal GDP averaged 4% a year even during the worst of "secular stagnation." So if I were to rely on the "round number" theory, I would put a lot more faith in 4%, as that is an even rounder number.

Once again, the fundamentals will win, with the fundamentals being forward Fed pricing.

Bond "Bubbles" -- Augh

The phrase "bond bubble" is back. That usage is an insult to any self-respecting bubble. In financial theory, people have tried to use a technical description -- a hyper-exponential price trajectory, based on the expectation that the asset can be sold to someone else also discounting a hyper-exponential price trajectory. Other commentators use a qualitative measure: is there mass participation by retail investors, and does the asset gain lots of popular coverage?

Unless a lot of people think that interest rates can get really negative, an asset that guarantees sub-3% nominal annual returns over 10 years (less than 30% cumulative) is never going to display hyper-exponential pricing. And face it, bonds are a hated asset class. The reason why editors run scary stories by bond bears is that they know that most of their readers hate bonds. Frankly, I am ex-secular bond bull and run a website whose domain name value is derived entirely upon an interest in bonds, and I can hardly get excited by them. (My idea of an exciting bullish headline is "Bonds: You Might Not Lose a Lot of Money in Real Terms!")

Bonds were arguably mispriced -- on the basis that you can now buy them cheaper. However, any losses on long-term bonds are still paper losses. If there is a recession within the next few years, 10-year bonds purchased earlier might still outperform cash if held to maturity.

Irrational, Or What?

The chart above shows the origin of the mispricing: the front end of the curve disrespected the Fed's intentions to hike rates over a relatively short time span. The fact that the Fed was taking baby steps in tightening probably helped the complacency. (In some years, it was one hike per year, whereas the historical pace was one hike per meeting, with eight meetings a year.) The 2-year is finally starting to work in a bit of a cushion.

That said, even if the front end continues to get hammered, bond bulls could come up for reasons for the curve to flatten (meaning that bond yields will rise less than one-to-one than the policy rate). It is not enough to expect forward rates to match the median Fed forecast (plus a term premium), an expectation has to incorporate the skew around the median forecast. Based on the post-1992 historical experience, the probability distribution is skewed towards a much lower policy rate in a recession, whereas accelerating inflation that justifies rapid rate hikes (as seen in the 1970s) has not happened. Even oil price spikes were not enough to trigger a second round of inflationary pressures.

In other words, it appears entirely rational for the bond market to rise slowly in response to Fed rate hikes, as the hard-to-judge probability of recession counters the rise in the baseline forecast for the path of the policy rate. When the Fed was hiking at a pace at 200 points a year, the tightening was front-loaded, and the skew due to recession probability is relatively less important. In that environment, it is not surprising that bear markets were also front-loaded, with most losses incurred almost immediately (or even before the first hike).

Finally, a rise in Treasury yields is not bearish for risk assets. The Fed is only going to raise rates in response to continued nominal growth, which implies that happy days for corporate profitability will continue. Inflation cutting into profit margins drastically would mean that labour is suddenly getting a bigger slice of the income pie, which seems somewhat optimistic. Faster nominal growth swamps the effect of a higher discount rate.

For those of you who don't know him, Brian Romanchuk is one of the smartest guys in the fixed income world. We worked together twice, once at BCA Research where he was helping to publish fixed income products and later at the Caisse where he was a senior quant analyst at the Fixed Income group.

Brian has a PhD in electrical engineering but his interests have evolved over the years into monetary economics, in particular modern monetary theory. He has published a few short books on Amazon that are well worth the price and I highly recommend his blog, Bond Economics, which delves into topics that are academic and market oriented.

Brian is also a genuinely nice guy with a quirky sense of humor. I remember plenty of conversations we had on bond bears and how many hedge funds got destroyed shorting JGBs over the last 20+ years.

The problem with bonds is people get way too excited without thinking things through. Readers of my blog know I'm not in the bond bubble camp because I worry about long-term structural deflation. Here is a sample of past comments where I discussed my thoughts:

The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.

Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending.

Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.

Globalization: Capital is free to move around the world in search of better opportunties but labor isn't. Offshoring manufacturing and service sector jobs to countries with lower wages increases corporate profits but exacerbates inequality.

Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create.

These are the seven structural factors I keep referring to when I warn investors to temper their long-term growth forecasts and to prepare for lower returns ahead as we enter a long period of debt deflation.

Essentially, what this means is long bond yields around the world are capped on the upside. Can long bond yields rise in the short run? Sure they can but as I keep telling you, don't confuse cyclical swings due to factors like short inflation bursts linked to lower US dollar and rising oil prices with structural factors that cap yields on the upside.

And when US long bond yields rise, long bond prices (TLT) fall, offering opportunities for investors to reduce risk in the portfolio by loading up on long bonds as they sell off.

In fact, this is what is happening now, and a quick look at the chart tells me this recent selloff in US lond bonds (TLT) is just another buying opportunity:

Can long bond prices fall further? Absolutely but as Brian states, "any losses on long-term bonds are still paper losses. If there is a recession within the next few years, 10-year bonds purchased earlier might still outperform cash if held to maturity."

Remember, the short end of the curve (yields up to the two year bonds) is influenced by the Fed and its intention to hike rates whereas the long end (10-year+ bonds) is influenced by US inflation expectations which are at their highest since 2014:

An important market measure of inflation expectations has risen to its highest level since 2014, as investor’s show strong demand to purchase protection against the threat of rising interest rates and declining bond prices.

The 10-year break-even rate, a market measure of inflation expectations derived from Treasury Inflation Protected Securities (Tips), has risen to 2.09 per cent, it’s highest level since September 2014 when oil prices were collapsing. The impact of oil prices on break-evens is strong, with analysts attributing at least part of the recent rise in inflation expectations to rising oil prices.

At a $13bn auction of Tips on Thursday, primary dealers — responsible for bidding on a pro rata share of the auction to ensure the sale of the debt — walked away with a smaller than average share of the securities, as other investors came in aggressively to buy.

“Bottom line, protection from inflation was in high demand in today’s auction,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group.

The 10-year Treasury yield has risen 20 basis points so far this year to 2.6 per cent on Thursday, closing in on its 2017 high of 2.63 per cent.

“Whether its wage fears or the rise in commodity prices, the inflation view is shifting and I repeat my belief that higher cyclical inflation in 2018 is a large under-appreciated risk,” added Mr Boockvar.

Wage inflation? A sustained rise in commodity prices? I don't see it. The simple explanation to this temporary rise in inflation expectations is the decline in the US dollar (UUP) over the last year, leading to higher oil prices and more importantly, temporary higher import prices:

I emphasize temporary because the decline in the USD cannot, I repeat, cannot continue indefinitely without global repercussions. Why? Because the USD is declining relative to the euro and yen, which effectively means these currencies are appreciating, lowering import prices in these regions, exacerbating deflationary headwinds there.

[Note: We shall see what happens with the NAFTA negotiations taking place in Montreal this week, but if they derail, and protectionism starts ruling the day, we might see a meaningful reversal in the USD. Even if they don't global PMIs weakening is bullish for the greenback. Period.]

Importantly, with global PMIs weakening, I expect we will see lower US long bond yields (higher bond prices) by yearend. You might not see this right now but I suspect by the second quarter, people aren't going to be talking about global synchronized growth any longer.

And without global growth, there's no way US long bond prices (TLT) are heading lower because they will offer the most attractive yields in the world.

Remember, and Brian alluded to this in his comment, asset allocators matching assets with liabilities are long duration, meaning they're scooping up US long bonds as yields rise (prices fall). Pension funds and other large institutions matching long-dated liabilities are using any backup in yields to de-risk their portfolio. This too places a natural ceiling on long bond yields.

So will the yield on the 10-year Treasury head to 3% this year and even 3.5% over the next two years? With global growth waning, I strongly doubt it, and if we get another crisis in the US or elsewhere, I can guarantee you long bond yields will head back down and make new secular lows.

Where I disagree with Brian is in his last paragraph where he says the rise in Treasury yields is not bearish for risk assets. That all depends on whether the Fed over-hikes and we get an inversion of the yield curve which is bearish for risk assets (see my Outlook 2018 for details).

Lastly, all this talk about technical breaks in US Treasury yields is much ado about nothing. In fact, Jeffrey Snider of Alhambra Investments wrote a comment, What About 2.62%?, poking fun at this silly notion. You can read this comment here and print it on PDF here.

I think too many investors worried about missing out on the great 2018 market melt-up are not focusing enough on downside risks.

I know it's hard to fathom but stocks don't go up forever and neither do bond yields. Always worry about downside risks especially in an environment where fear of missing out (FOMO) reigns supreme. When the music stops and the tide turns, you don't want to be caught with your pants down.

I think the biggest risk now is that stocks keep melting up in Q1 and more and more investors will start chasing them higher and higher at a time when the global economy is slowing. It won't end well for stocks but it will end well for bonds. That's my call so trade and hedge accordingly.

This interview took place last week, Danielle was recovering from a cold but take the time to listen to her comments. She talks about the problem with the Fed's favorite measure of inflation (core PCE), how Mother Nature played her part in this latest boom in US growth and saved the auto sector from marked slowdown, and why she likes Jerome Powell the new Fed Chair.

Interestingly, the "sugar high" she refers to is due to the billions in losses insurance companies sustained last year which are going back to rebuilding the US economy but in a conversation with Cornerstone Macro's François Trahan over the weekend, he said the "sugar high is from the delayed effects of lower global bond yields following the Brexit vote."

By the way, before I forget, subscribers to Cornerstone Macro's research should take the time to read the latest portfolio strategy comment, Anatomy of a Market Melt-Up, as well as last week's comment, 4 Top Risks to Our base case Outlook in 2018. Both are excellent comments worth reading.

As always, please remember to show your support for this blog via a PayPal donation or subscription on the top right-hand side under my picture. I thank all of you who take the time to support this blog.

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